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KKR the first private equity adviser to be charged by the SEC with misallocation of broken deal expenses in breach of its fiduciary duty

Why it matters: In the first SEC enforcement action of its kind brought against a private equity adviser, on June 29, 2015, the SEC announced that KKR had agreed to pay approximately $30 million (including a $10 million penalty) to settle charges that it had breached its fiduciary duty to the limited partners of its "flagship" private equity limited partnership investment funds by misallocating over $17 million in "broken deal" expenses to them.

Detailed discussion: On June 29, 2015, the SEC announced that it had charged private equity adviser Kohlberg Kravis Roberts & Co. (KKR) with misallocating more than $17 million in "broken deal" expenses (i.e., diligence, research, travel and other expenses incurred in connection with unsuccessful buyout transactions) to its "flagship" private equity limited partnership investment funds (Funds). KKR was also found to have failed to implement a written compliance policy governing its broken deal expense allocation practices. Without admitting or denying the SEC's factual findings, KKR agreed to the entry of an Order finding it to have breached its fiduciary duty to the Funds in violation of Sections 206(2) and (4) of the Investment Advisors Act of 1940 and related Rule 206(4)-7. To settle the charges, KKR agreed to pay approximately $14 million in disgorgement ($3.26 million was previously refunded to clients) as well as $4.5 million in prejudgment interest and a civil penalty of $10 million.

The press release states that the enforcement action against KKR was the result of an investigation being conducted by the Enforcement Division's Asset Management Division into the private equity industry focusing on whether investors are being unfairly charged with fees and expenses by fund managers. The SEC investigated KKR over a period of six years ending in 2011. The findings in the Order describe KKR as a "private equity firm that specializes in buyout and other transactions." The Order details KKR's complicated structure of investment funds and private equity investment vehicles, but we briefly boil down the SEC's findings relevant to this case here: In addition to the Funds, KKR advises and maintains other investment vehicles that invest with the Funds in buyouts and other transactions, including some that are affiliated with KKR through KKR partner ownership or other structural affiliation (KKR Co-Investors). The findings show that, during the relevant time period, KKR incurred roughly $338 million in broken deal expenses but that, with one limited exception in 2011 (after the implementation of a written compliance policy), none of those expenses were allocated by KKR to the KKR Co-Investors. Instead, the SEC found that KKR misallocated more than $17 million of the broken deal expenses to the Funds without disclosing the fact that it was doing so in its limited partnership agreements or related offering materials. Furthermore, the findings show that KKR did not implement a written compliance policy with respect to the allocation of broken deal expenses until 2011, six years after the start of the SEC's investigation.

SEC Enforcement Division Director Andrew J. Ceresney said in the press release that "[t]his is the first SEC case to charge a private equity adviser with misallocating broken deal expenses. Although KKR raised billions of dollars of deal capital from co-investors, it unfairly required the funds to shoulder the cost for nearly all of the expenses incurred to explore potential investment opportunities that were pursued but ultimately not completed." With respect to KKR's failure to have a written compliance program with respect to broken deal expense allocation in place, Marshall S. Sprung, Co-Chief of the SEC's Enforcement Division's Asset Management Unit said "KKR's failure to adopt policies and procedures governing broken deal expense allocation contributed to its breach of fiduciary duty. A robust compliance program helps investment advisers ensure that clients are not disadvantaged and receive full disclosure about how fund expenses are allocated."

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